Investment appraisal http://www.thestudentroom.co.uk/wiki/revision:investment_appraisal

PAYBACK

Works out how long it takes to repay the initial investment.

e.g. Investment A. costs £100. Annual return of £25 Length 5 years

YEAR NET CASH FLOW (ANNUAL RETURN)

CUMULATIVE CASH FLOW (CASH IN FLOW)

0 -100 -100

1 25 -75

2 25 -50

3 25 -25

4 25 0

5 25 25

Payback is 4 years.

Sometimes it is necessary to calculate the month of payback when the figure is reached part way

through the year. To do this you would you use formula:

ADVANTAGES

Easy to calculate

Easy to understand

Most relevant to businesses with cashflow problems

Emphasises speed of return – good in rapidly changing markets

DISADVANTAGES

Ignores money received after payback

Can be difficult to establish a target payback period

Doesn’t consider the future value of money

Short term approach

AVERAGE RATE OF RETURN

Compares profit with money invested.

To work this out, break it down into stages.

Calculate lifetime profit = total inflows – outflow

Divide by the number of years

Use the formula

e.g. Investment A cost £100 £25 return for 5 years

1. Inflow – outflow

£125 - £100

= £25

2. Divide by the number of years. 25/5 = 5

3. Use formula

5 / 100 X 100

= 5% return

ADVANTAGES

Percentage provides easy comparisons across projects

Shows the profitability of a project

DISADVANTAGES

Harder and more time consuming

Ignores time value of money

NET PRESENT VALUE (DISCOUNTED CASH FLOW)

This takes into account the time value of money. It is based on the principle that money is worth

more than it is in the future. The principle exists for two reasons:

Risk – money in the future is uncertain

Opportunity cost – Money could be in an interest account earning interest.

Discounting

This is the process of adjusting the value of money from its present value to its value in the future.

The key to discounting is the rate of interest. The business chooses the most appropriate rate for

the life of the project. It then identifies the discounting factor. The amount of money is then

multiplied by the discounting factors to convert it to its net present value.

e.g. Project A £100 £25 return 5 years

YEAR NET RETURN DISCOUNT FACTOR NET PRESENT VALUE

0 -100 0 -100

1 25 0.952 23.8

2 25 0.907 22.675

3 25 0.864 21.6

4 25 0.823 20.575

5 25 0.784 19.6

= £108.25

£108.25 MINUS INITIAL COST (£100) = £8.25

Profit = £8.25

ADVANTAGES

Considers the time value of money

Reducing discounting rate reduces future monies more heavily

Only one method that gives a definitive answer

Positive return – it is worth doing

DISADVANTAGES

Time consuming

More difficult to understand

Based on an arbitrary choice of interest rate